Week 13 Solutions

Chapter 19
14. WACC Table 19.4 shows a simplified balance sheet for Rensselaer
Felt. Calculate this companys weighted-average cost of capital. The debt
has just been refinanced at an interest rate of 6% (short term) and 8%
(long term). The expected rate of return on the companys shares is 15%.
There are 7.46 million shares outstanding, and the shares are trading at
$46. The tax rate is 35%.

We make three adjustments to the balance sheet:

Ignore deferred taxes; this is an accounting entry and represents
neither a liability nor a source of funds.
Net out accounts payable against current assets.
Use the market value of equity (7.46 million x $46).
Now the right-hand side of the balance sheet (in thousands) is:
Short-term debt
$75,600
Long-term debt
208,600
Shareholders equity
343,160
Total
$627,360
The after-tax weighted-average cost of capital formula, with one element
for each source of funding, is:
WACC = [rD ST (1 Tc) (D-ST/V)] + [rD LT (1 Tc) (D LT/V)] + [rE
(E/V)]
WACC = [0.06 (1 0.35) (75,600/627,360)] + [0.08 (1 0.35)
(208,600/627,360)]
+ [0.15 (343,160/627,360)]
= 0.004700 + 0.017290 + 0.082049 = 0.1040 = 10.40%
15. WACC How will Rensselaer Felts WACC and cost of equity change
if it issues $50 million in new equity and uses the proceeds to retire longterm debt? Assume the companys borrowing rates are unchanged. Use
the three-step procedure from Section 19-3.
Assume that short-term debt is temporary. From Problem 14:

Long-term debt
Shareholder equity
Total

$208,600
343,160
$551,760

Therefore: D/V = $208,600/$551,760 = 0.378

E/V = $343,160/$551,760 = 0.622
Step 1:
r = rD (D/V) + rE (E/V) = (0.08 0.378) + (0.15 0.622) = 0.1235
Step 2:
rE = r + (r rD) (D/E) = 0.1235 + (0.1235 0.08) 0.403 = 0.1410
Step 3:
WACC = [rD (1 TC) (D/V)] + [rE (E/V)]
= (0.08 0.65 0.287) + (0.1410 0.713) = 0.1155 =
11.55%
17. APV Consider another perpetual project like the crusher described
in Section 19-1. Its initial investment is $1,000,000, and the expected
cash inflow is $95,000 a year in perpetuity. The opportunity cost of
capital with all-equity financing is 10%, and the project allows the firm to
borrow at 7%. The tax rate is 35%. Use APV to calculate this projects
value.
a. Assume first that the project will be partly financed with $400,000 of
debt and that the debt amount is to be fixed and perpetual.
Base-case NPV = $1,000,000 + ($95,000/0.10) = $50,000.
PV(tax shields) = 0.35 $400,000 = $140,000.
APV = $50,000 + $140,000 = $90,000.
b. Then assume that the initial borrowing will be increased or reduced in
proportion to changes in the market value of this project.
PV(tax shields, approximate) = (0.35 0.07 $400,000)/0.10 =
$98,000.
APV = $50,000 + $98,000 = $48,000.
Explain the difference between your answers to (a) and (b).
The present value of the tax shield is higher when the debt is fixed
and therefore the tax shield is certain. When borrowing a constant
proportion of the market value of the project, the interest tax shields
are as uncertain as the value of the project, and therefore must be
discounted at the projects opportunity cost of capital.
18. Opportunity cost of capital Suppose the project described in
Problem 17 is to be undertaken by a university. Funds for the project will

be withdrawn from the universitys endowment, which is invested in a

widely diversified portfolio of stocks and bonds. However, the university
can also borrow at 7%. The university is tax exempt.
The university treasurer proposes to finance the project by issuing
$400,000 of perpetual bonds at 7% and by selling $600,000 worth of
common stocks from the endowment. The expected return on the
common stocks is 10%. He therefore proposes to evaluate the project by
discounting at a weighted-average cost of capital, calculated as:

Whats right or wrong with the treasurers approach? Should the

university invest? Should it borrow? Would the projects value to the
university change if the treasurer financed the project entirely by selling
common stocks from the endowment?
The immediate source of funds (i.e., both the proportion borrowed and
the expected return on the stocks sold) is irrelevant. The project would
not be any more valuable if the university sold stocks offering a lower
return. If borrowing is a zero-NPV activity for a tax-exempt university,
then base-case NPV equals APV, and the adjusted cost of capital r*
equals the opportunity cost of capital with all-equity financing. Here,
base-case NPV is negative; the university should not invest.
21. Issue cost and APV The Bunsen Chemical Company is currently at
its target debt ratio of 40%. It is contemplating a $1 million expansion of
its existing business. This expansion is expected to produce a cash inflow
of $130,000 a year in perpetuity.
The company is uncertain whether to undertake this expansion and how
to finance it. The two options are a $1 million issue of common stock or a
$1 million issue of 20-year debt. The flotation costs of a stock issue would
be around 5% of the amount raised, and the flotation costs of a debt issue
would be around 1%.
Bunsens financial manager, Ms. Polly Ethylene, estimates that the
required return on the companys equity is 14%, but she argues that the
flotation costs increase the cost of new equity to 19%. On this basis, the
project does not appear viable.
On the other hand, she points out that the company can raise new debt
on a 7% yield, which would make the cost of new debt 8%. She
therefore recommends that Bunsen should go ahead with the project and

finance it with an issue of long-term debt. Is Ms. Ethylene right? How

would you evaluate the project?
Note the following:
The costs of debt and equity are not 8.5% and 19%, respectively.
These figures assume the issue costs are paid every year, not just at
issue.
The fact that Bunsen can finance the entire cost of the project with
debt is irrelevant. The cost of capital does not depend on the
immediate source of funds; what matters is the projects
contribution to the firms overall borrowing power.
The project is expected to support debt in perpetuity. The fact that
the first debt issue is for only 20 years is irrelevant.
Assume the project has the same business risk as the firms other assets.
Because it is a perpetuity, we can use the firms weighted-average cost of
capital. If we ignore issue costs:
WACC = [rD (1 TC) (D/V)] + [rE (E/V)]
WACC = [0.07 (1 0.35) 0.4] + [0.14 0.6] = 0.1022 = 10.22%
Using this discount rate:
$130,000
NPV $1,000,000
$272,016
0.1022
The issue costs are:
Stock
0.050 $1,000,000 = $50,000
issue:
Bond issue: 0.015 $1,000,000 = $15,000
Debt is clearly less expensive. Project NPV net of issue costs is reduced
to:
($272,016 $15,000) = $257,016. However, if debt is used, the firms
debt ratio will be above the target ratio, and more equity will have to be
raised later. If debt financing can be obtained using retaining earnings,
then there are no other issue costs to consider. If stock will be issued to
regain the target debt ratio, an additional issue cost is incurred.
A careful estimate of the issue costs attributable to this project would
require a comparison of Bunsens financial plan with as compared to
without this project.